Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Liquidity support for central counterparties

The UK seems to be going in the opposite direction to the US in terms of providing liquidity support to clearing corporations or central counterparties (CCPs). In the US, the amendments by the Dodd Frank Act made it extremely difficult for the central bank to provide liquidity assistance to any non bank. On the other hand, the Bank of England on Wednesday extended its discount window not only to all CCPs but also to systemically important broker-dealers (h/t OTC Space). The Bank of England interprets its liquidity provision function very widely:

As the supplier of the economy’s most liquid asset, central bank money, the Bank is able to be a ‘back-stop’ provider of liquidity, and can therefore provide liquidity insurance to the financial system.

My own view has always been that CCPs should have access to the discount window but only to borrow against the best quality paper (typically, government bonds). If there is a large short fall in the pay-in, a CCP has to mobilize liquidity in probably less than an hour (before pay-out) and the only entity able to provide large amounts of liquidity at such short notice is the central bank. But if a CCP does not have enough top quality collateral on hand, it should be allowed to fail. A quarter century ago, Ben Bernanke argued that it makes sense for the central bank to stand behind even a failing CCP (Ben S. Bernanke, “Clearing and Settlement during the Crash”, The Review of Financial Studies, Vol. 3, No. 1, pp. 133-151). But I would not go that far. Most jurisdictions today are designing resolution mechanisms to deal with failed CCPs, so this should work even in a crisis situation.

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